The plasmid (or vector) used (pUC19 here) contains a gene called LacZ.  The LacZ gene codes for the production of an enzyme called beta-galactosidase.  This enzyme is made up of two fragments, alpha and omega.  When the two fragments are associated they form a functional enzyme.  Normally beta-galactosidase metabolizes galactose producing two products, lactose and glucose.  Beta-galactosidase converts other substrates such as X-Gal (5-bromo-4-chloro-3-indolyl-[beta]-D-galactopyranoside) into a colored product.  X-Gal is a colorless modified galactose sugar, however, when it is metabolized by beta-galactosidase the products are a bright blue.

In order for the gene to be actively transcribed from the DNA and for the enzyme to be produced, an activator called IPTG (isopropyl-[beta]-D-thiogalactopyranoside) must be added.  Both X-Gal and IPTG are delivered to the bacteria through the growth medium (generally a supplemented and enriched bacto-agar blend).

Within the LacZ gene there are multiple cloning sites where the plasmid may be cut and DNA may be added.  This produces a plasmid with foreign DNA located within the LacZ gene.  When transcription of the gene is activated by IPTG the foreign DNA that has been inserted is transcribed as well.  When the gene is later translated into the enzyme the inserted DNA is translated as well.  Because of its location within the enzyme the foreign DNA's translated protein product disrupts activity and function of the enzyme.  The disrupted enzyme activity is observed as a white bacterial colony.  (If the enzyme is functioning fully each colony is a bright blue color.)  Very small inserts of foreign DNA may lead to light blue colonies.
 

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